WASHINGTON, December 13, 2017 – US producer prices, as measured by the Producer Price Index (PPI), rose by .4% in November. For the prior 12 months through to November, the PPI increased by 3.1%. When producer prices rise, consumer prices usually follow, often with higher rates of inflation. This could be a major problem for economic growth, although proper tax cuts can ensure that this doesn’t happen.
Although the always volatile food and energy markets did see price increases in November, the core PPI which excludes food and energy also rose by .4%. If this rate continues annual inflation will near 5% for producers and perhaps more for consumers.
Tax Cuts effect on Interest Rates
It is critical that economic policy actions that are taken now grow the economy while keeping prices stable. Usually, economists define stable as consumer inflation at less than 3%.
If the PPI and consumers prices continue to rise, the Federal Reserve (FED) will act more aggressively to raise interest rates perhaps selling hundreds of billions of dollars of bonds to the public. While these actions will reduce demand in the economy and put downward pressure on prices, they will also put downward pressure on growth.
By selling bonds to the public the FED will be reducing potential capital to available to business.
As a result, it is critical that the inflation problem is solved in the market rather than by using Monetary Policy. That can be done through the proper use of fiscal policy and more specifically, income tax policy.
Producer prices are rising because demand is rising. Chris Rupley, chief economist at MUFG in New York recently says:
“This demand-led price push from higher commodity prices is a classic early warning signal that consumer goods will also see increasing inflationary pressures,”
Tax Cuts must create new capital.
Whenever rising demand creates inflation, the optimum solution to the problem is always to increase the supply to meet the demand.
Suppose a business is producing 10 vases per day and sells 10 per day. Somewhat because of tax cuts that gave consumers more money to spend, the business owner finds she can now sell 12 vases per day. There are now choices for the vendor to make:.
- Raise prices so that 2 customers no longer want to buy and continue to make 10 per day.
- She can raise her prices to earn enough capital to create more vases.
- Or she can expand her output to 12 per day through investing more into her business.
That means she can grow her business which benefits her directly and benefits the economy.
Labor and capital: What every expanding business needs
Although the unemployment rate is low, the labor force participation rate is very low. That means about 6 million workers stopped looking for a job because growth in the economy has been so dismal for the past 8 years. Better opportunities created through a growing economy will lure many of these workers back into the labor market.
The shop owner’s problem could be raising capital. Just as her business is growing so are other businesses who also require capital. Unless there is new capital there will not be enough to meet the needs of growing businesses. If she can’t raise capital, then she can’t expand. That means she will have to raise her price to create the capital to produce more.
How the tax cuts create new capital.
New capital comes primarily from three sources: corporate and business profit, personal income not taxed or spent and from capital gains. By reducing corporate taxes and taxes on pass-through businesses, there is new capital. It is critical that this tax rate is as low as possible, but no more than 20% on the corporate level.
The capital gains tax rate is not being reduced so the tax plan will not help capital creation there.
Most new capital comes from very high-income earners. These are people who pay very high rates of taxation (currently 39.6% on marginal income plus any state taxes) but who have significant amounts to invest after they pay the taxes and after they consume goods to maintain their lifestyle.
Unfortunately, regardless of the widely publicized inaccurate information, this is the only group whose tax rate does not fall. Since many live in states where the state taxes are highest, the loss of the deduction means they will likely pay more federal income tax.
More taxes mean less new capital.
A tax cut at the top rate, similar to what Kennedy/Johnson did in 1964 and Reagan did in 1981, would create new capital. This tax bill doesn’t do that.
The PPI is warning us that inflation may be a problem by the middle of next year unless we can set tax policy that can respond to increases in demand by appropriately increasing supply. The tax cut must create new capital, so the economy can increase supply.
Otherwise, we may end up with a stagnant economy with rising prices. Remember the stagflation in the 1970’s? Remember how tax policy in the 1980’s was geared to increase supply? For the next 20 years after the tax cut, the economy grew at more than 3.5% and inflation stayed below 3%?
Remember the supply side.